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FRBNY Economic Policy Review / May 2002 15

The Monetary TransmissionMechanism: Some Answers

and Further Questions

Introduction

hat are the mechanisms through which Federal Reserve

policy affects the economy? And has financial

innovation in recent years affected the monetary transmission

mechanism, either by changing the overall impact of policy or

by altering the channels through which it operates? These

were the questions examined by the conference Financial

Innovation and Monetary Transmission, sponsored by the

Federal Reserve Bank of New York on April 5 and 6, 2001.1 Our

goal in this overview is to summarize the conference papers and

distill from them some tentative answers to the questions posed

at the outset.

The overall conclusion drawn from the research presented is

that monetary policy appears to have less of an impact on real

activity than it once had—but the cause of that change remains

an open issue. The conference papers explored three

hypotheses en route to that finding. First, the transmission

mechanism may have changed as a result of the financial

innovations that motivated the conference, such as the growth

of securitization, shifts between sources of financing for

residential investment, or changes in the strength of wealth

effects. Second, a change in the conduct of monetary policy

may explain what appears to be a change in the effectiveness ofpolicy. Finally, the fundamental structural changes affecting

the economy ’s stability (and by implication, monetary

transmission) may be nonfinancial in nature. Also emerging

from the discussions was the consensus that a useful area forfuture research is to determine more precisely the role of each

hypothesis in the evolution of the monetary transmission

mechanism.

Negative findings are often as informative as positive ones,

however, and the conference succeeded in identifying three areas

where financial innovation has left the monetary transmission

mechanism largely unchanged. The first of these areas is the

reserves market, which has changed profoundly in recent years as

lower reserve requirements, higher vault cash holdings, and

innovations such as sweep accounts have dramatically reduced

the size of aggregate reserve balances. Yet despite these changes,

the Fed has retained its ability to influence overnight interestrates—and indeed has generally succeeded in keeping the

effective federal funds rate closer to its target than in years past.

Changes in the reserves market therefore may have had a

significant effect on the day-to-day implementation of policy, but

they have not diminished the Trading Desk ’s leverage over short-

term interest rates. Second, there is no evidence to suggest that

the quantitative importance of the wealth channel has changed

much in recent years. Its contribution to the impact of monetary

policy has always been modest, and that contribution has, if

anything, decreased somewhat since 1980. Third, while the

parallel trends of financial consolidation and globalization have

had a dramatic impact on financial services industries, thus far

the trends appear to have had no perceptible effect on monetary

transmission.

Kenneth N. Kuttner and Patricia C. Mosser

Kenneth N. Kuttner and Patricia C. Mosser are assistant vice presidents

at the Federal Reserve Bank of New York.

The authors are grateful to the conference participants and to Benjamin

Friedman for their comments on earlier drafts. The views expressed are those

of the authors and do not necessarily reflect the position of the Federal Reserve

Bank of New York or the Federal Reserve System.

W

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16 The Monetary Transmission Mechanism

Monetary Policy Transmission

Loan supply

Exchange rate

Relative asset prices

Real rates Asset price levels

Market interest rates

Collateral

Aggregate demand

Money supply

Fed funds rate Monetary base

Reserves

Open market operations

Narrowcredit

channel

Broadcredit

channel

WealthchannelInterest

ratechannel

Exchangerate

channel

Monetaristchannel

πe

A Monetary Transmission Schema

Monetary transmission is a complex and interesting topic

because there is not one, but many, channels through which

monetary policy operates. The exhibit depicts schematically an

eclectic view of monetary policy transmission, identifying the

major channels that have been distinguished in the literature.2

The process begins with the transmission of open market

operations to market interest rates, either through the reserves

market or through the supply and demand for money more

broadly. From there, transmission may proceed through any of

several channels.

The interest rate channel is the primary mechanism at work in

conventional macroeconomic models. The basic idea is

straightforward: given some degree of price stickiness, an

increase in nominal interest rates, for example, translates into an

increase in the real rate of interest and the user cost of capital.

These changes in turn lead to a postponement in consumption

or a reduction in investment spending. This is precisely the

mechanism embodied in conventional specifications of the “IS”

curve—whether of the “Old Keynesian” variety, or the forward-

looking equations at the heart of the “New Keynesian” macro

models developed by Rotemberg and Woodford (1997) and

Clarida, Galí, and Gertler (1999), among others. But as Bernanke

and Gertler (1995) have pointed out, the macroeconomic

response to policy-induced interest rate changes is considerably

larger than that implied by conventional estimates of the interest

elasticities of consumption and investment. This observationsuggests that mechanisms other than the narrow interest rate

channel may also be at work in the transmission of monetary

policy.

One such alternative path is the wealth channel , built on the

life-cycle model of consumption developed by Ando and

Modigliani (1963), in which households’ wealth is a key

determinant of consumption spending. The connection to

monetary policy comes via the link between interest rates and

asset prices: a policy-induced interest rate increase reduces the

value of long-lived assets (stocks, bonds, and real estate),

shrinking households’ resources and leading to a fall in

consumption.

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Asset values also play an important role in the broad credit

channel developed by Bernanke and Gertler (1989), but in a

manner distinct from that of the wealth channel. In the broad

credit channel, asset prices are especially important in that they

determine the value of the collateral that firms and consumers

may present when obtaining a loan. In “frictionless” credit

markets, a fall in the value of borrowers’ collateral will not

affect investment decisions; but in the presence of informationor agency costs, declining collateral values will increase the

premium borrowers must pay for external finance, which in

turn will reduce consumption and investment. Thus, the

impact of policy-induced changes in interest rates may be

magnified through this “financial accelerator” effect.

Like the broad credit channel, the narrow credit or bank

lending channel relies on credit market frictions, but in this

version, banks play a more central role. This idea goes back at

least to Roosa (1951) and was restated in an influential paper by

Bernanke and Blinder (1988). The essential insight is that

because banks rely on reservable demand deposits as an

important source of funds, contractionary monetary policy, by

reducing the aggregate volume of bank reserves, will reduce the

availability of bank loans. Because a significant subset of firms

and households relies heavily or exclusively on bank financing,

a reduction in loan supply will depress aggregate spending.

The exchange rate channel is an important element in

conventional open-economy macroeconomic models,

although it is often neglected in the closed-economy models

typically applied to the United States. The chain of trans-

mission here runs from interest rates to the exchange rate via

the uncovered interest rate parity condition relating interest

rate differentials to expected exchange rate movements. Thus,an increase in the domestic interest rate, relative to foreign

rates, would lead to a stronger currency and a reduction both

in net exports and in the overall level of aggregate demand.

Finally, there is also what might be described as a monetarist

channel—“monetarist” in the sense that it focuses on the direct

effect of changes in the relative quantities of assets, rather than

interest rates.3 The logic here is that because various assets are

imperfect substitutes in investors’ portfolios, changes in the

composition of outstanding assets brought about by monetary

policy will lead to relative price changes, which in turn can have

real effects. According to this view, interest rates play no special

role other than as one of many relative asset prices. Althoughthis mechanism is not part of the current generation of New

Keynesian macro models, it is central to discussions of the

likely effects of policy when, as in the case of Japan, there is a

binding zero lower bound on nominal interest rates (see, for

example, McCallum [2000]).

Needless to say, these channels are not mutually exclusive:

the economy ’s overall response to monetary policy will

incorporate the impact of a variety of channels. In considering

the possibility of changes in the transmission mechanism,

however, it is useful to consider each one in turn. That is the

approach taken by the papers in this volume, each of which

focuses on a particular channel and the structural changes

specific to it.

Three Measurement Challenges

It is a task for empirical research to assess the macroeconomic

impact of the various channels of monetary transmission

and to look for changes in the channels’ strength over time.

Empirical work on these issues, however, immediately comes

up against a number of challenges.

The first challenge is that of simultaneity . Typically, theFederal Reserve loosens policy when the economy weakens and

tightens when the economy strengthens; this endogenous

response of policy to economic conditions is one reason why it

is difficult to identify the effects of policy. This pattern is

illustrated by the correlations plotted in the top panel of the

chart: over the 1954-2000 period, the correlation between real

GDP and current and future (that is, negative lags of) funds

rate changes is positive. This does not, of course, mean that

interest rate increases are expansionary; rather, it reflects the

tendency of the Fed to raise interest rates in response to

unusually rapid real growth. The contractionary effect of

higher rates is apparent only after a lag of two quarters, as

shown by the negative correlation between GDP growth and

funds rate changes lagged two quarters or more.

Even in this very simple view of the data, there is evidence that

the link between policy and the economy has changed over time.

Comparing the 1954-83 subsample (middle panel) with the

1984-2000 subsample (bottom panel), we note two apparent

differences. First, the correlation between output growth and

subsequent funds rate changes is stronger in the later period—

evidence, perhaps, of more preemptive behavior on the part of

the Fed. Second, the correlation between funds rate changes and

subsequent quarters’ real GDP growth is weaker in the laterperiod—near zero, in fact—lending plausibility to the notion

that monetary policy has become less effective.

There is, however, an alternative explanation for the lower

correlation between the funds rate and the real economy:

monetary policy has actually become more effective in

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-0.50

-0.25

0

0.25

0.50Full Sample

Correlations between Real GDP Growth

and Lagged Funds Rate Changes

Lag of funds rate change (quarters)

Source: Authors’ calculations, based on data from the U.S. Commerce

Department’s Bureau of Economic Analysis and the Board of Governors

of the Federal Reserve System.

-0.50

-0.25

0

0.25

0.501954 to 1983

-0.50

-0.25

0

0.25

0.501984 to 2000

876543210-1-2-3-4

dampening real economic fluctuations. To illustrate this point,

we consider an extreme example. Suppose monetary policy

could be used to offset completely any fluctuations in real GDP

growth (leaving aside questions of whether this outcome is

either feasible or desirable), so that GDP expanded at a

constant rate. If GDP growth were completely stable, then it

would not be correlated with movements in the funds rate.

In the real world, of course, monetary policy did not (and can

not) keep output growth constant, but greater success in using

policy to stabilize output fluctuations could account for the

decline in the correlation between GDP growth and the funds

rate seen in the bottom panel of the chart. The two alternative

interpretations of the chart demonstrate why the simultaneity

problem creates a serious challenge for the interpretation of

any changes in the observed relationship between monetarypolicy and the economy.

Economists have employed a variety of techniques to solve

the simultaneity problem, but none is entirely satisfactory.

Perhaps the most common approach, and one employed by

several papers in this volume, is to use a vector autoregression

(VAR) model to purge interest rate changes of systematic

responses to economic activity and to focus instead on the

response to exogenous monetary policy “shocks.” Typically,

this is done by exploiting the presumed lag between policy and

its effects on real activity, which is apparent from the chart.

(Since financial markets respond immediately to policy, a

nonrecursive structure is more appropriate for modeling asset

prices.) However, critics of the VAR approach find it

implausible that the Federal Reserve behaves randomly, and

argue that the shocks really represent either model

specification errors or changes in the overall policy regime.4 In

addition, the VARs’ focus on shocks makes it hard to use them

to analyze changes in the systematic element of monetary

policy.5 Nonetheless, the method remains popular because it

offers a straightforward solution to the simultaneity problem

and appears to yield a reasonable characterization of the

economy ’s response to monetary policy.

Another way around the simultaneity problem is to useeconomic models with an explicit theoretical foundation,

calibrated in such a way as to approximate the behavior of the

economy.6 This approach, employed by two of the conference

papers, is much more amenable to the analysis of the types

of “what if ” counterfactuals that arise in the context of

investigating the transmission mechanism. Even these models,

however, ultimately rely on estimates of economic parameters,

and the simultaneity issue must be confronted at this stage.

Hence, calibrated theory-based models are a useful

complement to econometric models like VARs but cannot

altogether substitute for them.

Microeconomic approaches offer yet another way tocircumvent the simultaneity problem, but these too are fraught

with difficulties. Firm-level studies, for example, have been

used to estimate the interest and cash flow sensitivities of

investment spending and thereby assess the strength of the

interest rate and broad credit channels. By relying on cross-

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sectional or within-firm differences in the user cost of capital,

they eliminate the macro-level simultaneity problem described

above. But firms’ financing decisions can affect the user cost,

and this introduces a degree of micro-level endogeneity that

can complicate the interpretation of the results. The

microeconomic approach has also been effectively deployed in

assessing the bank lending channel, notably by Kashyap and

Stein (2000). But here too micro-level endogeneity can be aproblem, particularly when relationships with banks’ other

choice variables, such as holdings of liquid assets, are involved.

Furthermore, with any micro study, extrapolating from micro-

level results to macro-level effects will inevitably depend on

assumptions about the response of market participants. A

disproportionate impact of monetary policy on a particular

group of firms, for example, will have no macro effect if

other firms in the economy are able to “take up the slack.”

Ultimately, cross-sectional studies using micro data are

probably more informative about the micro-level distribution

of responses than they are about the overall macroeconomic

impact.

The second challenge in assessing the strength of any

particular channel of monetary transmission comes from the

concurrent operation of multiple channels. For example,

because we typically observe a fall in both output and bank

lending after a policy-induced increase in interest rates, it is

hard to tell how much of the loan decline to attribute to a

decline in loan demand (resulting from the interest rate

increase) and how much to the reduction in loan supply

implied by the bank lending channel. An analogous problem

confronts attempts to assess the strength of the wealth channel.

A common, if not entirely satisfactory, solution to this problemis to compare policy ’s estimated effect with its impact, with the

channel in question econometrically “turned off.” If the

remaining equations are assumed to be unchanged by this

intervention, then the difference between the two responses

can be interpreted as a gauge of the channel’s contribution.

Adding to these two challenges is the problem of isolating a

change in the strength of the channels of monetary

transmission. This problem is particularly daunting for a

number of the studies in this volume, thanks to the

evolutionary nature of the changes under consideration.

Changes in the use of securitization, the disintermediation of

credit formation, households’ equity holdings, and thefinancing of residential investment have all proceeded

gradually, as has the consolidation in the financial services

industry. Consequently, their effects on the transmission

mechanism, if any, will only become evident over relatively

long periods of time. Unfortunately, standard statistical

methods for detecting structural change work best for distinct,

abrupt events, such as the October 1979 shift in Fed operating

procedures or the oil shock of late 1973. Structural changes in

the monetary transmission mechanism have tended to be more

evolutionary; moreover, many of these changes have occurred

concurrently, making it even more difficult to separate out

their effects cleanly. Therefore, the scope for formal tests of

structural change is rather limited, and the studies in thisvolume instead tend to emphasize assessments of the economic

(as opposed to statistical) significance of the changes.

Survey and Synthesis

Taken together, the papers presented indicate that there have

indeed been significant changes in the linkages between the

basic instrument of monetary policy —reserves—and macro-

economic outcomes. But these changes do not necessarilyimply a change in the efficacy of policy. Reasons for these

changes can be found at two stages: first, in the linkages

between reserves and interest rates (the top half of the exhibit)

and second, in the connection between interest rates and

economic activity.

From Reserves to Interest Rates

The epicenter of monetary policy in the United States is the

reserves market: it is here that the overnight interest ratetargeted by the Fed is determined and open market operations

have their impact. Sandra Krieger’s contribution to the volume

provides an overview of some of the changes that have taken

place in this market in recent years, and in particular, the

declining volume of reserve balances and the diminishing

reliance on open market operations to effect rate changes.

Reasons for the decline in reserve balances include the decline

in required reserves as well as the adoption of “sweep accounts”

in the mid-1990s. In their paper, Paul Bennett and Stavros

Peristiani show that one side effect of these trends is that

reserve requirements are no longer binding for many banks,

and that this has weakened the link between the fed funds rateand banks’ desired reserve balances.

The implications of these changes for the link between open

market operations and interest rates are documented

empirically by Selva Demiralp and Oscar Jordá. Their main

finding is that prior to 1994, changes in the fed funds target

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were accompanied by systematic patterns in open market

operations. These patterns are no longer evident after 1994, yet

the effective federal funds rate seems to track its target more

closely than it did in the past. Meanwhile, the timing of

announced policy changes seems to have become a factor in the

response of term interest rates. From this evidence, Demiralp

and Jordá conclude that “announcement effects” have taken on

increased importance in recent years. These findings challengethe conventional view that open market operations are central

to the implementation of policy changes, but they are

consistent with Krieger’s description of the process.

Observing these trends, one could argue that the trends’

continuation could eventually undermine altogether the Fed’s

leverage over interest rates. Contributions by Michael

Woodford and by Marvin Goodfriend address this possibility

at a conceptual level. Each paper starts with the observation

that recent innovations to reserve management have decreased

the demand for the level of reserves, and that this may

eventually create some technical difficulties for Desk

operations. Neither author sees these innovations as a

fundamental threat to the Fed’s ability to influence interest

rates, however, and both note that further erosion in reserve

demand could easily be offset by changes to Desk operating

procedures. Based on other central banks’ experience,

Woodford suggests that a “corridor” system with interest-

bearing reserves and a Lombard-style lending facility would

effectively solve any foreseeable problems created by the

further evaporation in reserve demand. Goodfriend’s proposal

also involves interest-bearing reserves, but differs from

Woodford’s by envisioning an expansion in the level of reserves

sufficient to satiate the market. The result would be a systemthat, in theory, allows for separate control over both the

overnight interest rate and the quantity of bank reserves.

Interest Rates and Output

The relationship between the Federal Reserve’s target federal

funds rate and the behavior of the macroeconomy is the subject

tackled by another group of papers. The volatility of real GDP

has declined markedly since the mid-1980s, as documented by

McConnell and Perez-Quiros (2000). In this volume, Jean

Boivin and Marc Giannoni show that the economy ’s response

to monetary policy also appears to have declined over roughly

the same period.7 What was responsible for these changes? Are

changes in the transmission mechanism responsible, or were

they brought about by a change in the conduct of monetary

policy? Or was the cause perhaps some other structural change

in the economy, such as an innovation in firms’ management

of inventories with monetary policy passively responding?

In thinking about this question, it is useful to recall the

Frisch (1933) distinction between shocks and propagation: a

change in volatility may come about either because the size

of the shocks has diminished or because of weaker

propagation. Monetary transmission can be thought of as

encompassing the various ways in which monetary policyshocks propagate through the economy. But monetary policy

is more than just a source of shocks: the systematic response

of policy to macroeconomic conditions also affects the

propagation of monetary (and other) shocks. A more

strongly countercyclical policy, for example, will attenuate

the impact of shocks on output.

Boivin and Giannoni address this “shocks-versus-

propagation” issue directly, using a VAR analysis to assess the

effects of the reduced size of monetary shocks, changes in

monetary propagation, and other changes in the economic

environment. They find that the variance of monetary policy

shocks has indeed declined sharply since the early 1980s, but

this decline cannot account for the reduced volatility of output.

Instead, a change in the systematic response of policy to

macroeconomic conditions (a greater degree of “leaning

against the wind”) seems to account for most of the diminished

response to the shocks in their VAR. By implication, this

finding casts doubt on nonpolicy explanations for the

attenuation.8

Monetary policy is not the only factor in the propagation of

shocks, of course; other changes in the economic environment

may be at work as well. James Kahn, Margaret McConnell, and

Gabriel Perez-Quiros analyze the possible role of inventories,

which have historically been a major contributor to

macroeconomic volatility. The authors’ hypothesis is that

better inventory management, which has been made possible

by improvements in information technology, has attenuated

the propagation of demand shocks through inventories.

Specifically, the technology has allowed firms to anticipate sales

fluctuations better, so that production responds more

quickly —but less sharply —to sales fluctuations. Using

simulations of a small equilibrium model, the authors show

that such a change in inventory behavior can account for the

observed behavior of output and inventories, whereas a change

in the monetary policy rule cannot. These results stand in

contrast to those of Boivin and Giannoni, who ascribe a greater

role for monetary policy. The sharp differences in the papers’

findings exemplify the difficulties in measuring and testing for

changes in the transmission mechanism discussed earlier.

Further research using a framework that nests the two papers’

approaches is needed to resolve this issue.

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Financial Intermediation

In the past twenty years, a number of significant regulatory

and structural changes in the financial system have affected

monetary policy transmission. Regulatory changes—such as

the repeal of Regulation Q in the early 1980s and the bank

capital requirements mandated by the Basle Accord in 1988

and the Federal Deposit Insurance Corporation ImprovementAct in 1991— dramatically altered the incentives and the ability

of banks to lend as policy changed. Moreover, the steady

diminution of banks’ role in credit formation in the United

States—both via direct borrowing in financial markets and via

securitization of financial institution assets—has been

associated with increased competition in many lending

markets and has increased the importance of the price of credit

in the transmission mechanism. While most of the regulatory

and structural changes have reduced the importance of

outright credit rationing, their overall impact on the

transmission mechanism remains an open question.

Several papers in this volume consider the role of financial

intermediation in the transmission of monetary policy. In one,

Cara Lown and Donald Morgan directly examine the role of

bank lending standards to businesses as a determinant of real

economic activity, and provide new evidence on banks’

relevance to the transmission mechanism. Using a VAR

approach, they find that lending standards have important

predictive power for both loan volume and economic output.

These results provide strong support for the view that shocks

to bank lending are important, but because monetary policy has

little effect on lending standards, they give less support for the

bank lending channel as a central part of the transmissionmechanism. Lown and Morgan do, however, find that when

lending standards are added to the VAR model, they partially

displace monetary policy shocks in predicting real economic

activity. The authors hypothesize that this result reflects

policymakers’ use of “moral suasion” to reduce credit

formation during periods of monetary policy tightening.

The use of moral suasion has become less common in recent

years, however, raising the question whether lending standards

will continue to predict economic activity going forward;

tentative results for the 1990s, however, suggest that standards

have retained their predictive power. This raises the possibility

that bank lending standards may be a proxy for broader creditconditions at other financial institutions and in financial

markets. If so, then the continued predictive content of

standards is somewhat less surprising.

The effects of securitization are examined by Arturo Estrella,

who considers the degree to which asset securitization—and

mortgage securitization in particular—have affected the

transmission mechanisms of monetary policy. Using an

estimated structural IS equation, he finds that the sensitivity

of both real output and housing investment to the real federal

funds rate declined significantly as the degree of asset securiti-

zation increased in the 1980s and 1990s. Because the sensitivity

of mortgage interest rates to fed funds changes has, if anything,

increased, he suggests that securitization has largely affected

those channels not directly related to interest rates, such as thebank lending or credit channels.

Jonathan McCarthy and Richard Peach also study

securitization’s effects, but they focus more directly on the

housing market, using a structural model of housing

investment to examine how regulatory changes and other

innovations in housing finance have affected the transmission

of policy shocks to housing investment. Like Estrella, they find

that interest rates—as opposed to quantity constraints—have

taken on a larger role since the dismantling of Regulation Q

and the shift from thrift-based intermediation to a more

market-oriented system of housing finance. Perhaps as a

consequence of these changes, mortgage interest rates now

respond more quickly to monetary policy than they did prior

to 1986. Residential investment, however, responds more

slowly , and now fluctuates more or less concurrently with the

overall level of economic activity. An important implication of

the McCarthy-Peach paper is that the housing sector is no

longer in the vanguard of monetary transmission.

Skander Van den Heuvel and William English are more

forward-looking in their outlooks. The authors focus on two

factors—bank capital requirements and consolidation in the

financial services industry, respectively —that may well have

significant effects on the transmission mechanism, but havereceived little attention from researchers to date. English

discusses how the inexorable trend toward consolidation in the

financial industry might affect both the implementation and

the transmission of monetary policy. He zeroes in on the ways

in which consolidation might undermine central banks’ ability

to implement monetary policy and how the size and timing of

policy ’s effects may change as the financial system becomes

increasingly dominated by a small number of very large

institutions. These concerns appear to be largely unwarranted,

at least at present. A recent collaborative study by the Group of

Ten central banks, summarized by English, suggests that

financial consolidation has thus far had small effects on theimplementation of policy and virtually no effect on the

transmission of policy changes through the financial system.

Van den Heuvel probes the role of bank capital and capital

requirements in the transmission mechanism, and proposes a

“bank capital” channel of monetary policy. This channel is

related to the bank lending channel described above in that it

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involves policy-induced changes in bank loan supply. Instead

of viewing bank reserves as the relevant binding constraint,

however, it emphasizes the role of banks’ capital structure in

shaping the response of policy-induced interest rate changes.

Because poorly capitalized banks are less likely to lend than

well-capitalized institutions, the macroeconomic impact of

policy ’s effects through the bank capital channel will depend on

both the distribution and the level of bank capital ratios when

the policy change occurs. Bank capital requirements may

therefore interact with monetary policy in subtle and hard-to-

predict ways. Moreover, to the extent that it affects banks’

exposure to interest rate risk, the maturity distribution of bank

assets will also affect the transmission of policy.

The Role of Asset Prices

The transmission of monetary policy through asset prices is

analyzed from two different angles. Sydney Ludvigson, CharlesSteindel, and Martin Lettau scrutinize the empirical basis for

the wealth channel in the United States; Kosuke Aoki, James

Proudman, and Gertjan Vlieghe also analyze the role of wealth

in monetary transmission, but in the context of the broad

credit channel.

Using a structural VAR model, Ludvigson, Steindel, and

Lettau examine the response to federal funds rate shocks; to

assess the strength of the wealth channel, they compare the

estimated impact on consumption with the impact assuming

no response of asset prices. The authors f ind only small

differences in the response of consumption, and conclude from

this that the wealth channel is weak —much weaker than it is in

conventional structural macro models. In fact, their evidence

suggests that the wealth channel is slightly weaker now than it

was in the 1960s and 1970s, despite the growing importance of

equities in households’ portfolios. The reason for this may be

attributed to the transitory nature of asset values’ response to

funds rate shocks and the fact that consumption responds

strongly only to more permanent changes in wealth. The

Ludvigson-Steindel-Lettau findings suggest that rather than a

causal link from monetary policy to consumption by way of

asset prices, the apparent relationship between the three

variables may reflect the simultaneous response of asset valuesand monetary policy to common, underlying inflation

pressures.

In their study, Aoki, Proudman, and Vlieghe assess the

impact of monetary policy on the real economy through its

effect on housing prices, using a variant of the financial

accelerator model developed by Bernanke, Gertler, and

Gilchrist (1999) calibrated to U.K. data. The Aoki-Proudman-

Vlieghe model indicates that policy-induced changes in house

prices have in fact played a significant role in the transmission

of monetary policy in the United Kingdom. The authors also

find that recent financial innovations, such as more flexible

refinancing terms and increased consumer access to unsecured

credit, may have altered the transmission mechanism via

housing prices. Easier access to housing collateral in particular

has raised the sensitivity of consumption to house prices and

policy shocks, while increased access to credit cards has

weakened the link. Overall, the paper concludes that monetary

policy shocks now have smaller effects on housing investment

and housing prices in the United Kingdom, but slightly larger

effects on consumption.

Conclusions and Open Questions

A number of broad policy conclusions can be drawn from the

papers collected in this volume:

• Monetary policy ’s effects appear to be somewhat weaker

than they were in past decades. Financial innovation is

one possible cause of this change, but not the only one:

improved inventory management and the conduct of

monetary policy itself are others.

• Thanks to financial innovation and institutional changes

in housing finance, the housing sector is no longer on

the leading edge of the transmission mechanism.

However, judging from the evidence presented for theUnited Kingdom, the role of housing assets on

households’ balance sheets warrants further study.

• Neither financial consolidation nor the shrinking reserve

volume appears to be a major factor affecting monetary

transmission—at least not yet.

Some loose ends and lacunae remain, however. First,

although monetary policy seems to have retained its

effectiveness, the economy ’s sensitivity to interest rates remains

an open question. A comparison of the Estrella and Boivin-

Giannoni papers illustrates this issue. Both find that the

response of real activity to interest rates has diminished,

Estrella using a “structural” IS equation and Boivin and

Giannoni in the context of a monetary VAR. Estrella attributes

this to a change in intermediation brought about by securiti-

zation, and as Kahn, McConnell, and Perez-Quiros suggest,

improved inventory management may also have played a role.

Yet as Boivin and Giannoni show, the diminished response

may result not from less sensitivity to interest rates per se, but

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from the endogenous reaction of monetary policy. We thus

return to the simultaneity question: how is it possible to isolate

the effect of interest rates on economic conditions when

interest rates are themselves a function of economic conditions?

Second, given the decline in the relative importance of

banking, the corresponding growth in securitized lending

described by Estrella resists easy explanation, as do the changes

in housing finance documented by McCarthy and Peach andthe durability of the predictive content of bank lending

standards shown by Lown and Morgan.

Third, the absence of attention to an open-economy

channel running through the exchange rate is an important

lacuna. The omission does not mean that this channel is

unimportant; indeed, movements in net exports have played

an increasingly large role in U.S. macroeconomic fluctuations.

But a firm connection between economic fundamentals and

short-run exchange rate movements continues to elude

researchers, and this has frustrated efforts to pin down the

exchange rate channel empirically.9

These are, of course, not the only questions left unanswered

by the research presented at this conference, and the evolutionof the economy and the financial system is sure to raise new

questions. Consequently, the monetary transmission

mechanism will continue to be an important and fruitful area

for future research.

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Endnotes


1. The contents of this volume are also available at

.

2. A similar description of the channels of monetary transmission

appears in Mishkin (1995).

3. Meltzer (1995) summarizes this viewpoint. This monetarist

channel is similar in spirit, but considerably more sophisticated than

the earlier strand of monetarist thought based on the equation of

exchange, MV=PY .

4. Cochrane (1994) and Rudebusch (1998), among others, have made

these points.

5. Hard, but not impossible: see Boivin and Giannoni (2002b),

Bernanke, Gertler, and Watson (1997), and Sims and Zha (1995).

Hoover and Jordá (2001) provide a review and propose an alternative

method for assessing the effects of systematic policy.

6. The most commonly used models for this purpose are the New

Keynesian variety, such as those based on Rotemberg and Woodford

(1997) and Clarida, Galí, and Gertler (1999).

7. The decline in the response of output to monetary policy is also

documented by Taylor (1995), who uses an estimated structural

model of the economy.

8. In a separate paper, Boivin and Giannoni (2002a) consider non-

policy sources of structural change more rigorously, but find that the

sources fail to provide a satisfactory explanation for the observed

change in the economy ’s behavior.

9. See, for example, Flood and Rose (1995, 1999) and Kuttner and

Posen (2001).

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